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Inflation vs. Deflation: Who's Going to Win?

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Is inflation going to roar out of control from too much monetary stimulus? This is a question on the mind of every investor and consumer, from the economists on the FOMC with some control over those decisions, to you and I.

For nearly three years now, I have been a fan of the Bernanke Fed for doing an excellent job so far of fighting the war against a deflationary spiral, which he and I agree are the worse of two evils.

That war is not over and while some think he should have provided more extraordinary stimulus to jump start bank lending and investment that would lead to job creation and growth, the task is a difficult one to gauge because actions you take (or don't take) today have far-reaching effects tomorrow.

Even though Bernanke sees inflation subdued, we all feel the pinch at the pump and the grocery store. And businesses big and small absorb, or pass along, the impact of higher resource prices at all levels. Except of course wages, but that's another article about technology and productivity for another day.

So how bad is inflation now? And how bad could it get two to five years down the road if present policies keep stimulus flowing? That's a good question for the three dissenters on the FOMC committee. I should dig up some of their recent speeches and papers to see their projections.

Meanwhile, for some perspective, here's a big-picture look at inflation and growth for the US since 1947.

I like to look at the big picture when I hear people complain about what a gallon of gas or milk costs. Growth has a price and that price is inflation. See my article Bernanke: Growth is Our Destiny for more about growing our way out of this debt crisis.

If you are afraid of inflation and the evaporating value of the good ole US dollar, there's one sure-fire way to win in both the short and the long runs: equity investing. Easier said than done, I know. But that is our goal here and an earnings-based quantitative model proves over time that it's not as hard as most mutual fund managers make it look.

Volcker Weighs In On the Siren Song of Inflation

Economists are not as bad as everyone seems to think. Quantitative people who can look at complex, abstract puzzles with lots of moving variables are very useful, and not just as the butt of jokes.

I like a lot of central bankers who seem to think deeply about our problems and mine the data for trends and solutions. One in particular we should listen to is Paul Volcker who single handedly whipped inflation 30 years ago.

He felt strongly enough about our predicament last week to pen an op-ed for the New York Times. A passage is worth sharing, especially because it runs counter to why I like Bernanke so much...

After all, if 1 or 2 percent inflation is O.K. and has not raised inflationary expectations -- as the Fed and most central banks believe -- why not 3 or 4 or even more? Let's try to get business to jump the gun and invest now in the expectation of higher prices later, and raise housing prices (presumably commodities and gold, too) and maybe wages will follow. If the dollar is weakened, that's a good thing; it might even help close the trade deficit. And of course, as soon as the economy expands sufficiently, we will promptly return to price stability.

Well, good luck.

Some mathematical models spawned in academic seminars might support this scenario. But all of our economic history says it won't work that way. I thought we learned that lesson in the 1970s. That's when the word stagflation was invented to describe a truly ugly combination of rising inflation and stunted growth.

I was never so naive to think that mere inflation could cure all our structural problems. I said after QE was officially launched in March of 2009 that the systemic, generational housing/credit bubble and resulting crisis would take at least five years to fully heal.

But even as I still think deflation is the worse of two evils, I have to pause and at least respect the wisdom of Volcker that maybe we shouldn't grow our way of this mess at any cost.

SPXU and FOMC Update: S&P 1,220 proved to be formidable resistance even through the Fed-driven hopes this week. On Monday, I added to my short position via the ProShares UltraShort S&P 500 3X Bear ETF (SPXU - ETF report) and took some profits today on the drop. You can see the chart I've been using as my map to trade this "bear flag" formation in No Recession Scenario: Is the Bottom In?

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